To prove securities fraud, one has to prove reliance upon the allegedly fraudulent statement. This would be a problem in a class action: individual shareholders have relied upon different things in their decision to purchase, and some have never even seen the allegedly fraudulent statement. Under normal circumstances, the individualized nature of this inquiry would prevent class certification.

There is a way around this, though. The efficient market hypothesis propounded by financial economists theorizes that information is automatically reflected within a stock market price. Thus, if fraudulent information was out in the marketplace, it would have artificially inflated the stock price; a stock purchaser who never even saw the fraudulent information could thus be said to have relied upon the fraudulent information—thus, "fraud on the market." We'll leave aside the academic debate over the degree of truth of the efficient market hypothesis. What's important for our purposes today is that the Supreme Court has endorsed the fraud-on-the-market theory in Basic v. Levinson, and billions of dollars have changed hands because of it.

Andrew Trask notes that in the Amgen Supreme Court argument Monday, Justice Scalia mused that perhaps the Supreme Court should reverse Basic. I agree with Trask that this is an unlikely outcome in the short run. But securities lawyers should be aware that a major plaintiffs' firm, Bernstein Litowitz, has successfully argued in a federal district court case that a court can ignore the efficient-market hypothesis, which would imply that Basic v. Levinson is wrongly decided.

You might remember that the Center for Class Action Fairness objected to a $0 settlement in Johnson & Johnson. The objector argued that the settlement provided no benefit to shareholders. Plaintiffs responded by putting forth an expert declaration from former SEC chair Harvey Pitt opining that the minor corporate governance changes would have dramatic benefits for shareholders. In response, CCAF put forward expert reports from Professors Todd Henderson and Kate Litvak noting that Pitt's say-so was not competent expert evidence of shareholder benefit. As the CCAF brief argued, if the settlement created benefit for shareholders, that benefit would be reflected in the price of the stock. But the plaintiffs provided no evidence that the marketplace positively reacted to the changes in corporate governance; indeed, the JNJ stock price declined relative to the rest of the market. In the absence of the market evidence, we argued, plaintiffs failed to carry their burden that the settlement was beneficial to shareholders, and had no claim for $10 million in fees.

This is remarkable for several reasons. As an initial matter, if Harvey Pitt's say-so can be conclusive on the question of shareholder value above and beyond what actual market value shows, and a district-court judge has the ability to divine the creation of shareholder value in the absence of empirical evidence, both Pitt and the district court judge are making a huge financial mistake in staying in their current line of work. Both of them should be finding work with hedge funds, and trading stocks based on their power to determine which corporate governance reforms the market is failing to appropriately value.

But more importantly, Bernstein Litowitz has successfully argued to a district court that the efficient market hypothesis is wrong. According to Bernstein Litowitz, the market price of JNJ doesn't reflect all public information about the value of the stock, and there exist people like Pitt and the district court judge, and presumably others, who can divine shareholder value in ways the market cannot. But if that is so, then Basic v. Levinson is wrongly decided, because it means that one can't assume reliance on public information because the price of the stock differs from the underlying value of the corporation. Thus, there is no such thing as fraud on the market. Either the district court decision in Johnson & Johnson is correct, or the Supreme Court decision in Basic v. Levinson is correct, but they cannot both be correct.

I leave to others smarter than me which is the right way to view things. (That Pitt isn't opening a hedge fund suggests which way Pitt actually thinks.) But it would be fascinating if it turned out that, in its effort to defend a requested $10-million fee in an abusive shareholder derivative case, Bernstein Litowitz killed the multi-billion-dollar golden goose—the fraud-on-the-market theory—that permits shareholder fraud class actions at all. If there's a securities defense firm out there that argues judicial estoppel against Bernstein Litowitz based on the Johnson & Johnson decision, please let me know, and I'll post about it.

(The Center for Class Action Fairness is not affiliated with the Manhattan Institute.)

1 Comment

This would appear to be yet another example of a court deciding a case based on what it wanted the outcome to be, and relying on flimsy "expert" testimony to give cover for its decision.

There are numerous examples. A good one is Montoy v. State in which the Kansas Supreme Court ordered a massive increase in state school funding based on a single "expert" report. Where do these guys and gals get off? Isn't school funding an issue for the legislature, and not the judiciary? These are big decisions based on the flimsiest of evidence.

The same plaintiffs have tried to take the case up again, to get even more money. But the Kansas Supremes have demurred at the thought of readdressing the issue. A real threat to put supreme court justice appointments on the ballot and place their continued tenure in the hands of the voters or the legislators was probably just a coincidence.

And yet, there are at least 45 states now with lawsuits to increase school funding by judicial fiat. Can you say Teachers Unions?

There are a lot of objections to be made with the efficient market hypothesis. Timing is one. If all the farmers show up at the grain elevator on the same day, their wheat is virtually worthless because the market is glutted with wheat that day. That is why we have futures markets. But a futures market is only a guess, and is frequently wrong.

Same thing with stock prices. There are numerous ways to manipulate the price without disclosing anything. Short sellers can drive the price down by selling a tiny fraction of the existing shares. This can trigger computerized selling of the stock elsewhere driving the price down artificially. Then when the shorts all cover, the price is driven too high. Yet there is no real time information on how many short sells there are at any given time. So a person relying on stock price alone is likely to be duped on the way down and on the way up. It has nothing to do with the underlying value of the corporation.

The same thing happens in the commodities markets. World gold prices are continuously manipulated to reflect an untrue price by a few big operators who buy, hype the market through advertising, sell short and repeat the whole process again.

However, if the courts want to accept the efficient market hypothesis for expediency, so be it. But it would be nice to have a little consistency in the decisions.

At least in the Basic case, we were dealing with a tangible drop in the market price and a question of whether merger talks were material to that drop. Or whether the talks were even going on. Those seem to be reasonable questions of fact.

Whether Harvey Pitt can divine what the price of a stock should be, rather than what it is, seems to be less a question of fact. That would appear to be better answered in a metaphysical realm. Perhaps by clergy. Or psychics. Or mental health practitioners. Which then brings us back to the court. What can we say about a trier of fact which relies on this kind of expert testimony?

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